Money matters

Tips for sewing up that hole in your pocket

DENVER (CBS.MW) - Given the dismal state of the U.S. stock market over the past three years, it's only natural that many equity mutual fund shareholders feel trapped on a rock and in a hard place. Investors are sitting in equity funds that lost more than they dreamed possible, and many aren't sure whether to tough it out or sell out.

MKTW: Many investors are sitting on big losses in some of their stock funds, particularly aggressive funds that bought heavily into technology, media and telecom during the late '90s boom. Should they hang tough?

Cassidy: If a person has a fund with a significant loss, especially if it's in a taxable account, they should pull the trigger and move on. Holding is the same as buying.

MKTW: Moving to greener pastures sounds great, but where?

Cassidy: It's true that not every fund that's down is a bad fund. But if a fund is an underperformer, and you bought because it looked nice, you probably got into an asset class when it was hot. If you can replace a laggard with a similar and better fund, do it now. Over the next year or so, people are going to be very skittish about getting into risky things. They're going to like value-oriented funds that pay dividends. That's another reason to not hang with large-cap growth or technology funds; other types will do better.

A good bet now are funds that invest in Treasury inflation-protected bonds, or TIPS. You're going to get the inflation rate of about 2 percent plus about 2.5 to 3 percent in yield. You're not taking long-bond risk and not accepting low return on short-term paper. You've bought a variable-rate bond fund.

MKTW: What advantages do investors gain by selling a losing fund from a taxable account?

Cassidy: Here's the math: Say you have a fund that unfortunately is down 50 percent -- some tech funds are down 80 percent -- and it's in a taxable account. If you hold that fund, you need a double just to get back to even.

Suppose instead you sell the fund and book a long-term capital loss. You're going to get a 20 percent tax benefit on your loss from the federal government, plus another 5 percent or so from the state where you live. That 25 percent is your tax benefit. This is not a credit that runs out; you can use it forever. Say you started in a fund at $10,000 and are down to $5,000. If you sell, the government is going to give you $1,250, or 25 percent of $5,000. That's within the $3,000 limit of capital losses you can take each year. So you've got $6,250 to work with for new investment.

If your $10,000 is down to $2,000 - an 80 percent loss - the tax benefit on the $8,000 loss is $2,000. Let the investment sit, and it's worth $2,000. Sell it and take the tax benefit, and it's worth $4,000 to you. So the fund is worth twice as much dead than alive. Inertia costs you a lot of money.

If your losses are greater than $3,000, you might have a position with a low-cost basis where you've said "I can't sell that; the gain is too big." Now you can sell to offset the loss. Otherwise you've got to take the $3,000 limit year by year.

MKTW: You certainly put this in stark terms.

Cassidy: The numbers get pretty amazing, but that's the math. People have a hard time taking a loss; it's an admission of error. Well, we're human beings; we're not perfect. Don't expect so much from yourself. Control your ego and move on.

MKTW: Some investors are indeed moving on - out of stocks and into bonds, money markets and certificates of deposit. As an investor, how do you know when you've strayed too far from stocks?

Cassidy: Financial planners use a so-called "rule of 110." Take 110, subtract your age and put a percentage sign behind the result. That's roughly the amount of a portfolio you should allocate to equities. That's how it should be. The older you get, the less exposed you should be to equity risk.

That said, someone 70 years old should still have 40 percent of investment assets in equities. It certainly doesn't have to be wild. They can be equity-income, real estate, utilities, and value-style funds rather than growth.

MKTW: Total return from utilities funds over the past year has been terrible, though their income yields are still reasonably attractive. Evidently these funds aren't as stodgy as they might seem.

Cassidy: If you buy a utilities fund for high yield, you're actually buying the highest risk. If the dividend is cut, the fund's value will go down. If you're still in your working years and don't need the income, why pay the taxes and why take the risk?

Go for lower yield with growth. What you'd like is a fund where 10 or 15 years from now both the dividend and the price have doubled. Also, be careful to look for utilities funds that are not heavy in telecom, because telephone companies have a lot of overcapacity and are constantly fighting it out on rates. Find funds that haven't done crazy stuff and have stayed in their own backyard. The same principle applies to real-estate funds.

MKTW: You watch investor trends closely. What are investors doing now that worries you?

Cassidy: Money going into high-yield funds bothers me. People are stretching for yield, but look around you and tell me how wonderfully healthy you think the economy is. I'm not sure I'm ready to own junk bonds yet.

Another concern is the outflows from money market funds. Who wants a yield below 1 percent? But people have gone to banks and locked themselves into three-, four- and five-year certificates of deposit. They're not going to regain confidence for a long while. You can have a moderately rising market and they're not going to be ready to write checks. It's going to take time for people to heal.

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